Neglected risks, financial innovation and financial fragility

We present a standard model of financial innovation, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash flows. Financial intermediaries cater to these preferences and beliefs by engineering securities perceived to be safe but exposed to neglected risks. Because the risks are neglected, security issuance is excessive. As investors eventually recognize these risks, they fly back to safety of traditional securities and markets become fragile, even without leverage, precisely because the volume of new claims is excessive.

Private borrowing during the financial revolution: Hoare’s Bank and its customers, 1702-1724

The financial revolution improved the British government s ability to borrow, andthus its ability to wage war. North andWeingast argued that it also permitted privateparties to borrow more cheaply and widely.We test these inferences with evidencefrom a London bank.We confirm that private bank credit was cheap in the earlyeighteenth century, but we argue that it was not available widely. Importantly, thegovernment reduced the usury rate in 1714, sharply reducing the circle of privateclients that could be served profitably.

Productivity growth and the exchange rate regime: The role of financial development

This paper offers empirical evidence that a country's choice of exchange rate regime can have a signifficant impact on its medium-term rate of productivity growth. Moreover, the impact depends critically on the country's level of financial development, its degree of market regulation, and its distance from the global technology frontier. We illustrate how each of these channels may operate in a simple stylized growth model in which real exchange rate uncertainty exacerbates the negative investment e¤ects of domestic credit market constraints. The empirical analysis is based on an 83 country data set spanning the years 1960-2000. Our approach delivers results that are in striking contrast to the vast existing empirical exchange rate literature, which largely finds the effects of exchange rate volatility on real activity to be relatively small and insignificant.

Dynamic optimal law enforcement with learning

We incorporate the process of enforcement learning by assuming that the agency's current marginal cost is a decreasing function of its past experience of detecting and convicting. The agency accumulates data and information (on criminals, on opportunities of crime) enhancing the ability to apprehend in the future at a lower marginal cost.We focus on the impact of enforcement learning on optimal stationary compliance rules. In particular, we show that the optimal stationary fine could be less-than-maximal and the optimal stationary probability of detection could be higher-than-otherwise.

Optimal law enforcement under asymmetric information

In this paper, we focus on the problem created by asymmetric informationabout the enforcer's (agent's) costs associated to enforcement expenditure. This adverse selection problem affects optimal law enforcement because a low cost enforcer may conceal its information by imitating a high cost enforcer, and must then be given a compensation to be induced to reveal its true costs. The government faces a trade-off between minimizing the enforcer's compensation and maximizing the net surplus of harmful acts. As a consequence, the probability of apprehension and punishment is usually reduced leading to more offenses being committed. We show that asymmetry of information does not affect law enforcement as long as raising public funds is costless. The consideration of costly raising of public funds permits to establish the positive correlation between asymmetry of information between government and enforcers andthe crime rate.

Recreating the South Sea bubble: Lessons from an experiment in financial history

Major bubble episodes are rare events. In this paper, we examine what factors might cause some asset price bubbles to become very large. We recreate, in a laboratory setting, some of the specific institutional features investors in the South Sea Company faced in 1720. Several factors have been proposed as potentially contributing to one of the greatest periods of asset overvaluation in history: an intricate debt-for-equity swap, deferred payment for these shares, and the possibility of default on the deferred payments. We consider which aspect might have had the most impact in creating the South Sea bubble. The results of the experiment suggest that the company?s attempt to exchange its shares for government debt was the single biggest contributor to the stock price explosion, because of the manner in which the swap affected fundamental value. Issuing new shares with only partial payments required, in conjunction with the debt-equity swap, also had a significant effect on the size of the bubble. Limited contract enforcement, on the other hand, does not appear to have contributed significantly.